In the past, India has undertaken expensive foreign currency-denominated borrowing from NRIs through Resurgent India Bonds, India Millennium Deposit bonds and dollar-denominated deposits. This time, the government is proposing to issue a small sovereign bond.
The risk is small, considering the size of the borrowing, the inflation-targeting monetary policy framework and the fiscal responsibility law. The government and the Reserve Bank of India need to primarily manage risk through sticking to the Fiscal Responsibility and Budget Management Act and inflation-targeting frameworks.
In addition, the government should set up a Public Debt Management Agency (PDMA), which takes a comprehensive view of the government’s debt, its costs, currency denomination, tenor and time of issuance.
Why foreign currency borrowing is risky
The main difference between a dollar-denominated loan, as proposed in the Union Budget speech, and a rupee-denominated loan, is in who holds the risk of rupee depreciation. When an Indian borrower takes a loan in dollars, she has to pay back in dollars. If, in the meantime, the value of the dollar versus the rupee changes, the loss or gain accrues to the borrower. In addition to the interest rate, the borrower needs to pay back more if the rupee weakens. The borrower is ‘exposed’ to currency risk. For this reason, borrowing in domestic currency is expected to be safer than borrowing in foreign currency.
But risks can be managed. For example, foreign currency borrowing of private borrowers can be made safer by ‘hedging’ one’s exposure. It is possible there is a natural hedge. If one is an exporter who earns in dollars, then even when the exporter borrows in dollars, she is not putting her balance sheet at risk. On the other hand, if the borrower is a domestic builder, her earnings are in rupees, and if the rupee depreciates sharply, she may not be able to pay back the loan.
Another way of hedging currency exposure is to buy derivatives. There may be someone who may be willing to enter into a contract with you, at a price, to supply you dollars at today’s exchange rate. The cost for the loan is now the interest rate and the cost of hedging.
If the government of India were to borrow from international markets, it will have currency risk. So, for example, if it borrows at 2 per cent per annum in dollar terms in international markets, and if the rupee weakens by 2 percent per annum, then in rupee terms, it will pay back 4 per cent in rupee terms.
Uncertainty over exchange rates
A number of factors play a role in the movement of exchange rates. A purchasing power parity model may forecast that the rupee will depreciate by the difference in the inflation rates for India and the US. The Balassa-Samuelson model may predict that because of faster productivity increases in India, it may appreciate. Some may argue that higher imports and slower exports will make the rupee weaken. Others may feel that the inflow of foreign investment into India will keep the rupee strong.
One possibility is that to get away from the uncertainty, India should do ‘masala bonds’, i.e. borrow in rupees. Interest rates for rupee borrowing are higher, at around 7 per cent. Alternatively, we could let foreigners buy more Indian government bonds in Indian markets. This way, we would know exactly how much we will be paying in rupee terms.
Three necessary reforms
In recent years, India has adopted an inflation-targeting monetary policy and the FRBM Act. The fear of large depreciations is based on the fear that the government and the RBI will not respect these mandates. As a consequence, governments will be profligate and borrow a lot, inflation will be high and the rupee will depreciate.
In addition to the other problems that will be created by such policies, foreign borrowing will add more problems of India defaulting on its foreign debt. Even though the government is currently saying it will borrow only a very small part of the debt in dollars, the fear is that it will be irresponsible if it “tastes” cheap foreign capital, and over time, it will borrow much more in dollars.
These fears are based on confusion in fiscal data, off-budget borrowing and missed revenue targets of the government on the one hand, and the belief that the effectiveness of monetary policy in India is limited.
Three key reforms are necessary. First, the government needs to bring much greater transparency to the budget. Two, the RBI needs to improve the transmission of monetary policy. And three, the government needs to set up a professional Public Debt Management Agency that manages various aspects of its debt, including how much should be borrowed in foreign currency.
If the government borrows in foreign currency, it has to manage risks by allowing the RBI to stick to its mandate of inflation targeting, and by itself sticking to FRBM targets, in both letter and spirit. Greater trust in the country’s data will reduce risk of panic by foreigners or sudden outflows.
The pressure of being watched by the world is a good commitment device. A prudent and responsible government can actually gain by having international bond markets as its watch-dog.
The author is an economist and a professor at the National Institute of Public Finance and Policy. Views are personal.